All eyes on the Aussie dollar
With the share market growing at a slow pace, 2014 is likely to be a year of consolidation for Australia, write Roger Bridges and Jason Kim. But the dollar could be the wildcard in an otherwise foreseeable market.
In 2013, the Reserve Bank of Australia (RBA) cut the official cash rate twice to an historic low of 2.50 per cent.
In our view, this easing cycle has come to an end and we envisage the cash rate remaining at 2.50 per cent for most of this year, with a possible rate hike in the fourth quarter depending on whether the current “green shoots” of economic growth prove sustainable.
The RBA continues to be concerned about lower levels of mining investment and the need to rebalance the economy to other sources of growth. Although we have recently seen improvements in domestic data, particularly in the housing market, it seems that the RBA is in wait-and-see mode for now.
It believes that there is “mounting evidence that monetary policy (is) supporting activity in interest-sensitive sectors and asset values, and given the lags with which monetary policy operates, the stimulatory effects would likely continue coming through for some time”. (Source: Minutes of the Monetary Policy Meeting of the Reserve Bank Board, 5 November 2013).
However, it’s important to note that the RBA remains troubled by what it sees as the uncomfortably high exchange rate.
The announcement by the US Federal Reserve that it would begin tapering its quantitative easing (QE) program pushed the Australian dollar to three-year lows and it started the year at around US$0.89. Although this depreciation is positive, with the Australian dollar having fallen by over 14 per cent during 2013,
RBA governor Glenn Stevens has explicitly stated that he would prefer the currency closer to US$0.85.
This means that further rate cuts cannot be entirely ruled out given how concerned the RBA is about the exchange rate.
However, we expect the currency to continue to weaken somewhat over the year due to a stronger US dollar as QE tapering comes to an end and the US recovery continues.
Australian long-term bond yields may start to drift up on the back of expected rises in the US 10-year Treasury rate, given that the US economy appears to be recovering and QE is coming to an end.
However, if market expectations for the Australian cash rate remain unchanged, then Australian yields may not rise in step with US Treasuries and we could see the spread between Australian and US bonds contract, somewhat protecting Australian investors from US rate increases.
We observed the start of this trend in December 2013 and envisage that the spread may continue to contract, with US Treasury yields rising significantly more than Australian 10-year yields if the economic performance of the two countries continues to diverge.
In the last four easing cycles that Australia has seen, rate hikes have happened within at least one year of the last rate cut.
However, many of these easing cycles occurred because of events overseas, such as the 1997 Asian crisis, the dot.com bubble, 9/11, and the GFC.
In the current easing cycle there is a large domestic element, with low rates needed to ease the transition of the economy from being driven by mining investment growth to export growth.
Additionally, those previous easing cycles saw a major fall in the exchange rate, which acted as a shock absorber for the economy and reinforced the impact of low interest rates.
This time the reversed happened, with the Australian dollar actually appreciating on negative shocks from overseas, which has hurt exchange rate-sensitive sectors like manufacturing.
This means that this cycle will be different from those that have prevailed in recent history – with sub-par growth, there is a risk that these ultra-low rates will prevail for longer than in previous cycles.
Australian equities
The Australian share market has experienced a significant re-rating over the past two years, with the S&P/ASX 200 Accumulation Index rising a cumulative 45 per cent.
Given such strong performance and a relatively soft outlook for the Australian economy, Tyndall expects more subdued returns in the Australian share market in 2014.
The market’s gains over the past two calendar years were largely driven by a re-rating in the price to earnings ratio (PE). The forecast (12-months forward) PE has moved from 10.6x earnings in December 2011 to 14.7x in December 2013. At this level, the market is considered to be slightly expensive relative to its long-term PE average of around 14x.
The increase in the PE is due solely to a rise in share prices, reflecting growing confidence in the global economy, increased risk appetite and record low interest rates (due largely to the massive quantitative easing programs from the US, Japanese and European central banks).
With the PE having re-rated, earnings growth needs to follow in order for the market to move much higher. We believe that an earnings recovery is more likely to occur in 2015 than in 2014.
While earnings will be assisted by an improvement in company bottom lines, reflecting the considerable cost cutting and scaling back of capital expenditure programs undertaken by corporates in 2013, top-line revenues – particularly for domestic-focused companies – are likely to continue to struggle.
As noted above, the interest rate cuts by the RBA are having an impact on the economy, with retail sales and housing both picking up, but they are not providing the usual boost experienced in previous recoveries.
A number of companies have been adopting self-help strategies to help them adjust to structural changes in the economy and weak consumer demand.
They have been implementing sizeable cost-out strategies, involving significant reductions in their labour forces.
Employment concerns coupled with high household debt have seen Australian households choosing to pay off their mortgages rather than spend their newfound savings on consumer goods.
Housing prices, approvals and land sales are all rising and there are early stages of a pick-up in housing construction, but the benefits of the latter aren’t expected to flow through to earnings until late 2014 and early 2015. New homes often require new whitegoods and furniture as households opt for a refresh.
There is typically an eight-month lag from when construction starts to when installation of household appliances commences.
The upcoming company reporting season will, as usual, be eagerly anticipated by investors. The impact of the weaker Australian dollar and lower interest rates on earnings will be keenly watched. We expect cost cutting to be an ongoing theme in 2014 as the self-help strategies continue to play out.
Tyndall expects 2014 to be a year of consolidation in the Australian share market. With the economy growing at sub-par levels, company earnings are likely to remain relatively weak, keeping overall share returns relatively low.
In a low total return environment, dividends are likely to be the primary contributor to total share market returns. Interestingly, despite the S&P/ASX 200 Price Index still being around 20 per cent below its November 2007 high, the Accumulation Index is actually 10 per cent above its record high – highlighting the power of dividends in the Australian market.
This environment should also be positive for undervalued stocks, as investors hunt for better-priced alternatives in a relatively expensive market. There are pockets of value to be found, which is ideal for bottom-up stock pickers.
Global outlook
Cyclical stocks with offshore exposure is one area where the Tyndall Australian equities team has been finding value.
Australia has relied on the Chinese economy for a lot of its growth in recent years, but there are a number of Australian companies that derive a large portion of their earnings from offshore markets, notably in the recovering US and European economies. A weaker Australian dollar adds further support to these offshore-exposed corporates.
The Australian dollar could prove to be a real wildcard for the economy and the share market this year, particularly in the resources sector if commodity prices stabilise or indeed move higher.
Roger Bridges is head of fixed income and Jason Kim is portfolio manager and senior analyst with Tyndall AM.
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